An issue that is the subject of intense debate among academics and financial professionals is the Efficient Market Hypothesis (“EMH”). The hypothesis states that the price of a security is an accurate reflection of all available information.
Individuals, corporations, and other entities purchase securities and derivatives under the assumption that the securities they purchase are worth more than the price that they are paying. Similarly, sellers of derivatives and securities assume that the services they are selling are worth less than the selling price. However, if markets were completely efficient and contemporaneous prices fully reflected all information available, then outperforming the market would become a matter of happenstance. As a result, if a market could be completely efficient, there would be no information or analysis that could result in over-performance of an expected benchmark.
A completely efficient market would be a market in which rational, profit-oriented entities compete and try to predict future market values of individual securities and derivatives. Information would be freely available to all participants. In an efficient market, competition between entities would result in a situation where actual prices of individual securities and financial derivatives would already reflect the effects of events that have occurred. In addition, prices would reflect events which are expected to take place in the future. In short, an efficient market would allow an entity to know the actual value of a security or other financial instrument at any point in time.
There are three forms of the Efficient Market Hypothesis: the weak form, the semi-strong form, and the strong form. The weak form assumes that all past market prices and data are fully reflected in financial derivative securities prices. In other words, technical analysis is unnecessary because market price already reflects that which can be analyzed from a technical standpoint. The semi-strong form assumes that all publicly available information would be fully reflected in securities prices. In other words, fundamental analysis would be of no use because the information utilized in such an analysis would already be incorporated into the price. The strong form assumes that all information is fully reflected in securities prices. In other words, even insider information would be of no use (i.e., insider information would already be incorporated into the price of a commodity.)
In practice, markets are neither perfectly efficient nor completely inefficient. All markets are efficient to a certain degree, and some are more efficient than others. In markets with substantially low efficiency, more knowledgeable investors can often outperform less knowledgeable investors. For example, government bond markets are considered to be extremely efficient. Most researchers consider large capitalization stocks to also be very efficient, while small capitalization stocks and international stocks are considered by some to be less efficient. Real estate markets and venture capital markets, which do not have fluid or continuous markets, are generally considered to be less efficient because different participants may have varying amounts and quality of information. In addition, many markets are flooded with thousands of intelligent, well-paid, and hard-working investors seeking under and over-valued securities to buy and sell. Efficiency of a market is largely dependent on the number of participants and the rate of dissemination of information.
Efficiency of markets plays an important role in the decision to invest. Because more efficient markets more accurately reflect available information, prices are relatively stable and reliable. As a result, entities can offer various securities and derivatives which have a value based on the underlying stable prices. For example, bond markets and stock markets are well known markets having relatively stable prices. Conversely, markets that are considered inefficient such as the real estate market and various venture capital markets are more speculative in nature. As such, underlying prices may be very unstable. Accordingly, established derivative and securities markets are lacking.
An established market utilizes a variety of financial instruments. These instruments are used for a variety of purposes, from investing in a given stock to hedging risks wherein parties exchange derivative instruments in order to offset the price risk associated with fluctuations in cash markets.
Many entities including commercial firms, consumers, and producers utilize hedging techniques to protect against price risk. Hedging enables a party to transfer risk to another party because the parties leverage related products and services which respond similarly to the same economic factors. This leverage of related products and/or services is known as correlation.
An entity can use any of several derivatives for these purposes. The simplest of such derivatives is known as a forward contract, which is a transaction wherein a buyer and a seller agree upon price and quantity for delivery of a specific service or commodity at a future point in time. Forward contracts are not standardized, so each transaction must be negotiated individually. In addition, while such forward contracts are legally binding, upon default a party must resort to the legal system for recovery. Accordingly, transaction costs associated with negotiating, maintaining and enforcing forward contracts are often unnecessarily high.
Of course, these contracts can be standardized as to include specific terms. Standardized forward contracts or futures contracts are generally standardized with respect to quantity, time, and place for delivery of goods and services. Because futures contracts are standardized, an entity can theoretically purchase and sell futures contracts without ever actually taking physical delivery of the subject of the contract.
To eliminate the need for legal enforcement of a forward contract, a margin system was created to prevent buyers and sellers from defaulting on their contract. In a margin system, the buyer and the seller of a futures contract deposit cash to a margin account maintained by a third party, usually an exchange or a bank, as collateral to guarantee performance of the futures contract. In addition, a margin may be “marked-to-market,” whereby the amount of money deposited into a margin account is updated continuously as the price of the underlying derivative fluctuates.
Since the terms of a futures contract are standardized and delivery need not ever be completed, a properly executed contract is all that is required for buying, selling, and trading the contract, making the process fairly liquid. To improve the liquidity of this process, exchanges were formed to facilitate these transactions on a larger scale. Currently, exchanges are the preferred forum for trading futures contracts because risk managers appreciate the benefits of standardized features.
Futures options are analogous to futures contracts. The difference between the two is the fact that with futures options a party is not actually obliged to actually accept delivery of the underlying commodity. Instead, a party has the right to refuse delivery. The result is that unlike futures contracts, futures options are not subject to margin calls (i.e., the instrument is not marked to market unless a party actually takes delivery) and have lower potential risk. There are disadvantages to purchasing a futures option. For example, because one party has the right to refuse delivery of the futures option, the futures option is more expensive to purchase that a futures contract. The higher price negatively impacts the return of the instrument, resulting in a lower yield. Because the yield is lower, it is a more inefficient risk management tool than a standardized futures contract.
As an example, consider a wheat farmer who wishes to sell his upcoming harvest. While prices for his crop remain steady, the farmer is worried that the value of his crops at harvest time will drop. The farmer (seller) can agree to deliver his wheat at harvest time to a miller, (buyer), who is worried that the price of wheat will increase between the contract date and the harvest (delivery) date. The farmer and the miller have both attempted to manage the risk of the commodity, namely wheat. Note that if the price of wheat rises, the miller is said to gain value because the contract was executed at a lower price. Conversely, if the price of wheat falls, the farmer gains value because the contract was executed at a premium over the price the farmer could have obtained.
The same principles hold for intangible financial products and services. For example, consider an entity that holds a contract to sell a product in a foreign market that will be paid for in foreign currency. If the foreign currency increases in value relative to the domestic currency, it will convert into less domestic currency. To protect itself against this currency risk, the domestic entity can buy a foreign currency futures contract. Similar to the farmer/miller example, if the foreign currency appreciates, the loss on conversion on the initial contract is offset by the increased value of the futures contract.
In addition, efficient markets allow investors and other entities to buy and sell financial instruments known as securities. A security is a type of transferable interest representing financial value. There are two general classes: debt securities and equity securities. Both types are represented by a certificate. For example, shares of corporate stock, bonds issued by corporations or governmental agencies, and mutual funds are all examples of securities.
Issuers (i.e., sellers) of securities include commercial companies, government agencies, local authorities and international and organizations. Debt securities issued by government generally carry a lower interest rate than corporate debt issued by commercial companies.
Entities typically utilize securities to raise new capital because they are an attractive option relative to bank loans which tend to be relatively expensive and short term. Through securities, capital is provided by investors who purchase the securities. In a similar way, a government can raise capital from securities if taxation and other income are insufficient to meet public expenditure.
Investors (i.e., purchasers) include investment banks, insurance companies, pension funds, individuals, and other corporations. Investors purchase securities to receive income and/or achieve capital gains.
The holder of a debt security is owed a debt by the issuer and is entitled to the payment of principal and interest, together with other personal rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and are redeemable by the issuer at the end of that term. They generally offer a higher rate of interest than bank deposits.
Another example of a debt security is a treasury bond, which is a medium or long term debt security issued by a government. It typically carries lower interest rates than corporate bonds (i.e., they offer less yield). In addition, money market instruments such as certificates of deposit and commercial paper are classified as securities. They are short term, highly liquid, and offer low interest rates.
An equity derivative, in contrast, is typically considered to be an ordinary share in a company. The principal advantage of equity is the prospect of capital growth.
Securities markets are divided into primary markets and secondary markets. Primary markets (also known as capital markets) are comprised of new securities to their first holders (e.g., an Initial Public Offering). Issuers usually retain investment banks to assist them in finding buyers for these issues, and in many cases, to buy any remaining interests themselves. This arrangement is known as underwriting.
Transferability is an essential characteristic of securities. Transferring, or trading of these securities is done on the secondary market. Secondary markets are often referred to as stock exchanges. The value of securities sold on exchanges is determined by the number of willing buyers and sellers (i.e., the market determines their value). As a result, efficient capital markets are vital to their success.
Efficient capital markets allow entities to better hedge their risk. However, entities do not hedge against every contingency. If the risk that needs to be hedged has only a small impact on an entity's bottom line, it may decide that hedging against that risk is unnecessary. Accordingly, an entity typically only hedges large expenditures and/or commodities that substantially impact the bottom line due to their underlying volatility.
For example, consider an entity that has a large exposure to inflation. To manage this risk the entity can purchase and/or trade a Consumer Price Index (CPI) future. The CPI index is a measure of inflation based on publicly available information. Since almost every entity is exposed to inflation related price risk there is a large market for buyers and sellers who wish to manage this risk and the CPI index market trades at a high volume. While it can be generally utilized effectively to hedge short-term changes in inflation, and the index price is stable because it is based on government-published historic data, it is a new type of futures contract. As such, the total number of contracts available is limited. In addition, the CPI index is not an accurate measure of the volatility of uncorrelated products and services (e.g., healthcare) because uncorrelated products and services increase in price at a different rate than inflation.
By way of example, healthcare costs in the United States are presently increasing at two to three times the rate of inflation and at four times the rate of wage increases. In an attempt to measure the increase in healthcare costs, entities rely on the healthcare trend, which indicates the percentage increase of healthcare expenditures per capita over a predetermined period of time. The components of the healthcare trend are highly variable, making the healthcare trend extremely volatile. Therefore entities that attempt to manage health related expenditures have difficulty budgeting and forecasting these costs due to this volatility, which affects the entity's bottom line. Because of the direct impact of sharply rising healthcare costs on an entity's financial stability, managing the price risk of healthcare related costs is vital.
For example, a Fortune 100 company like General Motors has high financial exposure to such risk factors as currency risk, credit risk from its financing division, interest rate risk from its financing division, and fuel cost risk from the sale of automobiles. These financial risks are correlated to significant sources of revenue from (or significant expenditures related to), automobile products and services. General Motors therefore hedges against these risks in one form or another by utilizing financial derivative instruments.
In 2003, General Motors (GM) spent $4.8 billion on healthcare for its employees, which constituted an expenditure greater that its expenditure for steel. Because healthcare costs comprise a large percentage of General Motor's expenditures, one would expect it to manage its healthcare risk by utilizing financial derivatives.
However, no such market exists. There is no market for tangible financial derivatives because the healthcare industry is extremely inefficient. Rather than allow the traditional market forces of supply and demand to dictate the price of providing healthcare, a “command and control” system is utilized for managing healthcare expenditures. As a result, corporations such as General Motors must utilize more traditional healthcare management techniques to control the costs associated with providing healthcare.
Cost management techniques include health insurance, alternative procurement strategies, on-site medical facilities, employer network creation, and lifestyle/wellness management programs. Further, corporations often alter existing health insurance plans by making benefit adjustments, imposing access restrictions, altering eligibility requirements, and creating alternative healthcare plans.
Insurance premiums associated with such insurance have been rising at an alarming rate due to increasing costs that reflect the inherent variability of the healthcare industry, such as the cost of prescription drugs. In addition, insurance premiums are inflated, for example, by transaction costs related to contract maintenance and contract negotiations. Similarly, administration of these plans is extremely costly because plans are not standardized (i.e., they are corporation specific). As a result, the present system for managing risk associated with healthcare costs (i.e., health insurance) is inefficient.
As premium costs continue to rise, insurance companies presently offer a variety of insurance types in an attempt to manage price risk and volatility of healthcare expenditures.
One type of the insurance now offered is a method of reducing healthcare costs known as stop-loss insurance.
Stop-loss insurance can be purchased by self insured employers in an attempt to stabilize their healthcare costs. While a typical self insured employer can predict the approximate number of doctor visits its employees will have in a given year, it cannot predict the number of “catastrophic events” (e.g., premature births, cancer, and organ transplants) that will occur in a given year. The costs associated with these procedures can be devastatingly high to a self insurer so there is a need to hedge against this type of risk.
There are two main types of stop-loss insurance. The first is known as Individual Stop Loss “ISL,” sometimes called Specific Stop Loss. Individual Stop Loss protects an employer against large claims incurred by an individual employee or dependent which exceed a predetermined dollar limit chosen by the employer. For example, if an employee of the insured incurs injuries in an accident that requires expenditures that far exceed the policy's stated deductible, the ISL insurance would reimburse the employer for all associated expenses beyond a predetermined dollar amount.
The second type of stop-loss insurance is known as Aggregate Stop Loss (ASL), or Excess Risk Insurance. Aggregate Stop loss insures an employer against the total expenditures by its employees as compared to a predetermined dollar amount. An employer typically purchases ASL to cover against 125% of the level of expected claims predicted by the insurance carrier. For example, a mid sized self insurer with $4 million in expected claims could purchase a stop loss policy that initiates when $5 million in claims are incurred.
Despite the obvious advantages associated with the various types of stop loss insurance, there are numerous disadvantages. For example, conservative pricing and limited availability of stop loss insurance policies severely curtails the usefulness of stop loss insurance to small health plans with limited financial resources. In contrast, large companies can afford the costs associated with a few catastrophic claims, so the steep cost of stop loss insurance becomes economically wasteful.
In addition, like traditional insurance, stop loss premiums are inflated, for example, by transaction costs related to contract maintenance and contract negotiations, as well as costly administrative expenses.
Consequently, stop loss insurance is limited to mid-sized self insured employers because such entities often do not have large enough cash reserves or generate enough income to cover the costs associated with several catastrophic claims. In addition, stop loss insurance solutions only maintain extreme volatility because typical stop loss plans do not take effect until the incurred claims exceed a 25% threshold. Thus, current insurance practice is highly inefficient.
The current process of determining pricing associated with healthcare is extremely inefficient. Currently, the government determines public healthcare prices utilizing the Resource Based Relative Value Scale (RBRVS).
The RBRVS is published annually by the government as a component of the Medicare Physician Fee Schedule by the Center for Medicare and Medicaid Services (CMMS). In short, the RBRVS assigns a relative value to individual medical procedures and services based on the government's determination of the complexity of the procedure or service, rather than the market value of such a procedure. By way of example, the current relative value for an initial office visit is 0.97, while the relative value of a heart transplant is 98.59.
To determine the suggested retail price of a procedure or service, the relative value is multiplied by a physician's conversion factor (e.g., $100.00) and modified by a series of multipliers which purport to account for regional variability. These factors include the Geographic Cost of Practice Index (GCPI) and the Geographic Adjustment Factor (GAF). The GCPI attempts to take into account factors such as geographic practice expenses and medical malpractice insurance expenses. For example, the practice expense multiplier in San Francisco is 1.501, while the multiplier for South Dakota is 0.365.
The GAF is purports to more accurately reflect fees for associated with a specific city, county, area, region and state. As an example, the GAF multiplier for Detroit is 1.610, while the GAF for South Dakota is 0.747.
Therefore, to achieve the final value of any particular medical procedure or service in a particular region, the RBRVS for that procedure of service is multiplied by a conversion factor, GCPI and GAF.
As a result, the government attempts to set RBRVS values using formulas and statistics as opposed to natural supply and demand. This process is inherently inefficient because the government necessarily sets higher values for some services and lower values for others than would be established through supply and demand dynamics. This inefficiency is further compounded by the need for multiple geographic factors. Since most private healthcare payers utilize the government's methodology as the basis for contract negotiations with providers, the process perpetuates and magnifies the valuation problem.
Additional market inefficiencies exist in regards to private healthcare providers. Currently, private providers negotiate with each healthcare provider individually, thereby increasing transaction costs such as legal fees and wasting limited financial resources. Further, subjective factors such as the reputation of a party, personal connections between negotiators, and previously agreed upon pricing are utilized to determine the price of healthcare for a given contract. This negotiation process leads to the proliferation of asymmetric information, negatively influencing the efficiency of any potential market. As a result, the cost to provide healthcare is inordinately high and volatile.
Because there are no healthcare risk management techniques which utilize tangible financial derivatives to control escalating healthcare costs, there is a clear need in the art for a tangible financial instrument which is capable of being traded in an efficient market. The present invention overcomes the various deficiencies associated with this shortcoming by creating a novel tangible financial instrument in the form of a derivative contract or a security product that allows entities to effectively and efficiently hedge the highly volatile fluctuations associated with predicting healthcare costs by converting healthcare products and services into commodities and constructing a financial instrument with an underlying value based on the commodity.